Picking Sectors as the Market Rotates

Investec Ernst's John Garrity likes health care, defense, and energy as they offer growth at a reasonable price

The stock market is still in for a rough ride over the next few months. Such is the view of John J. Garrity, associate research director of Investec Ernst. He sees the possibility of an upturn in the second half of 2001. But he tempers this with concern about energy prices' negative effects on consumers and the impact of bad corporate earnings news on investors.

Garrity thinks that the market in the near term will be characterized by rotation among sectors. For now, he suggests concentrating on pharmaceuticals and health care, defense, and energy. When asked to name three favorite stocks, he cites Photelectron, Level 3, and Comstock Resources.

Although he thinks "surprisingly few" long-term businesses will emerge among the Internet plays, Garrity likes the stocks of CNET and Penton Media. He also favors Microsoft for its R&D push in high-growth areas beyond the PC.

Garrity's observations were made in a chat presented on Feb. 8 by BusinessWeek Online on America Online, in response to questions from the audience and BW Online's Jack Dierdorff and Amey Stone. Following are edited excerpts from the chat. A complete transcript of this chat is available from BW Online on AOL, keyword: BW Talk.

Q: John, it looks like sort of an off-again, on-again market -- and today looked off-again. How do you diagnose the situation?

A: I would say we have a market that remains very undecided and is waiting for a catalyst. Right now at least, there seems to be little impetus to rally, but at the same time, there's only limited selling pressure. That's probably going to translate into a market that fails to follow through on either rallies or reactions. That means a continued rotation in and out of industry sectors and groups.

Q: What kind of catalyst are you looking for?

A: Well, I think what the market is looking for is further guidance on where the economy is headed. We believe the next few months will be tough for the economy, but in the second half, we believe we might see an upturn.... One negative factor that still affects the marketplace is soaring energy costs, which could overcome the benefits of lower interest rates by reducing the spending power of consumers.

Q: On your views about "continued rotation," what sectors would you be looking at now?

A: First and foremost, the pharmaceutical and health-care sector. Second would be energy, third would be defense.

Q: What are your thoughts on Cisco?


We have taken a posture of "growth at a reasonable price" in tech stocks.... We have suggested avoiding the highfliers like Cisco (CSCO ), EMC (EMC ), Sun (SUNW ), and the other white-hot sectors.... Although we think that the wireless, optical, and networking equipment industries all have terrific long-term growth prospects, we think that the market's growth estimates for these industries are still too high. We would watch Cisco, Ciena (CIEN ), Nokia (NOK ), and Juniper (JNPR ) very carefully to find more attractive entry points to commit any new money.

Q: Can Lucent (LU ) turn things around in the long term?


Clearly, we think Lucent can. In our view, the telecom-service industry is entering the initial stages of deregulation, which portends continued market-share erosion and pricing disruption over the next two to three years. At this juncture, we believe the local Bells have the high ground, given high barriers to entry in their local networks, which produce a stable cash flow. In this industry, we like SBC Communications (SBC ), Qwest (QWST ), and Verizon (VZ ).

Q: What are your three favorite stocks to buy?


No. 1, Photoelectron Corp. (PHX ), No. 2, Level 3 (LVLT ), No. 3, Comstock Resources (CRK ). The first is a medical-devices company, the second a telecom company, and the third is in the natural-gas industry.

Q: Reasons for your choices?


Sure. On Photoelectron, this is a medical-device and technology company specializing in miniature X-ray technology for the medical and industrial markets.... Yesterday, Johnson & Johnson's Cordis division announced a joint venture with this company in the cardiovascular field, and JNJ took a 10% stake in this company.

On Level 3, it's at the forefront of a great change in the telecom industry from utility to technology. We believe the company will dominate "backbone" information transmission and develop a great business franchise in the process. We think the stock is undervalued at current levels.

Comstock Resources, my third choice, is an independent exploration and production company which acquires, develops, and produces and explores oil and natural-gas properties. I would add that the company is one of the few that have not hedged their natural-gas prices. This allows the company to benefit significantly from higher gas prices.

Q: How do you feel about the B2B [business to business] sector?

A: E-commerce companies should continue to see volatility in 2001. On the B2B side of the equation, we would also expect to see some further volatility as growth rates slow in the face of spending declines by dot-coms and traditional companies alike.

Q: Do you see any hope for pure Internet plays?

A: At this stage, no.... There will be surprisingly few long-term businesses that will be created. However, we do like some content companies, like CNET and Penton Media (PME ), which has a great Internet trade show franchise that's highly profitable. I would add that Yahoo! (YHOON ) and eBay (EBAY ) are businesses we like, but valuations are still high. We rate Amazon (AMZN ) a hold.

Q: Any thoughts on Microsoft (MSFT)?

A: We also like Microsoft (MSFT ) because we believe it's in the early stages of a great product cycle, and huge levels of R&D are being poured into high-growth opportunities outside the PC sector. We believe, in short order, that Microsoft will cease to be known as a PC software company.

Q: You mentioned you like Microsoft, but not as a PC company. Do you think the PC era, and Wintel dominance, are over?

A: I would say no, I don't think it's over. However, in the hardware sector, we favor Unisys and Compaq (CPQ ) as they have more attractive valuations than their competitors. We think Dell is attractive in the $20 range, for example.

Q: Where do you see the Nasdaq in the next three months?


I would expect the Nasdaq to continue to trade in the same levels we've seen throughout January and February. I think what investors need to look out for is companies' guidance for September quarter results.... So far, the market has discounted disappointing earnings from many companies. This signals a semi-bullish tone. But if these earnings warnings continue for the second half, investors will begin to turn very negative.

Q: Some analysts now favor retailers, but with your concerns about consumers, would you avoid them?

A: With the stock market correction and a slowing economy crimping consumer spending and confidence, the retail industry will be hard pressed to match the 7% sales growth it rang up in 2000. In addition, the retail sector has been beset by a myriad of fourth-quarter earnings warnings. Names like Best Buy (BBY ), Neiman Marcus (NMG.A ), and AnnTaylor (ANN ), to name a few.

Our favorite stock in the retail sector continues to be Wal-Mart (WMT ) because the company has quickened the pace of its reconfiguration of stores into supercenters that sell groceries -- 75% of all households now shop at Wal-Mart.

Q: Given your tentative outlook on the next few months, is the best advice really to stay on the sidelines? What should investors do who have some cash now?

A: I would say investors don't need to sit on the sidelines, but they do need to exercise caution. We believe investors would be wise to follow our mantra of growth at a reasonable price. Due to the uncertain economic environment, we would continue to be defensive -- and hence our reasoning for being bullish on the pharmaceutical, energy, and defense areas.

Edited by Jack Dierdorff

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